Is CKD (TSE:6407) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, CKD Corporation (TSE:6407) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for CKD

How Much Debt Does CKD Carry?

The image below, which you can click on for greater detail, shows that CKD had debt of JP¥36.0b at the end of June 2024, a reduction from JP¥37.9b over a year. On the flip side, it has JP¥28.1b in cash leading to net debt of about JP¥7.94b.

How Healthy Is CKD's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that CKD had liabilities of JP¥44.9b due within 12 months and liabilities of JP¥35.4b due beyond that. Offsetting these obligations, it had cash of JP¥28.1b as well as receivables valued at JP¥39.2b due within 12 months. So it has liabilities totalling JP¥13.0b more than its cash and near-term receivables, combined.

Given CKD has a market capitalization of JP¥173.9b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

CKD has a low net debt to EBITDA ratio of only 0.37. And its EBIT easily covers its interest expense, being 57.3 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for CKD if management cannot prevent a repeat of the 25% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine CKD's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, CKD saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While CKD's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. Taking the abovementioned factors together we do think CKD's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example CKD has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.